National Institute of Economic and Social Research

Thursday, 5 April 2012

Long term interest rates and confidence, continued..

I still seem to have difficulty getting across the very simple point that the historically low level of long-term interest rates in the UK (gilt yields) reflects primarily protracted economic weakness rather than, as the government persists in asserting, confidence in the government's economic strategy. Maybe this chart will do the trick:

The chart shows the value of the FTSE-250 (a somewhat better reflection of the UK corporate sector than the heavily international FTSE-100) against 10 year gilt yields. The correlation is pretty obvious; higher equity prices have gone along with higher long-term interest rates. Both reflect the fact that, since the turn of the year, the economic news has been better, with business confidence clearly improving, even it is yet to show through in the official data.

"Either you believe that we are going to return to normal economic growth reasonably soon or you believe that gilt yields should be very low, but you cannot believe both. If you believe that economic prospects are reasonably good, the current level of gilt yields just does not add up."

The markets agree. Will the government and other commentators finally recognise the overwhelming evidence, both theoretical and empirical? I'm not holding my breath.

Mainstream economists tend to think that in recessionary times government spending crowds-out private investment. This is wrong of course. In these times what is lacking is investment opportunities. This in turn means everyone goes into government debt because it has at least some return.

When government spends more into the economy demand increases. This demand creates investment opporunities and investors take on these more risky investments with better returns. Increased demand (through govt spending) floats all boats.